Software-defined networking, which allows network administrators to control a network through software, was viewed as a major threat to Cisco's (NASDAQ:CSCO) business model a few years ago. Cisco is the dominant player in the networking hardware market, and its share of the switching and routing markets dwarfs those of the company's nearest competitors. But cheap, commodity networking hardware coupled with software had the potential to upend Cisco's very profitable operation.
Except for some large web companies that have the resources to design their own switching hardware, SDN has yet to have a negative impact on Cisco's business. Cisco launched its own take on SDN, called Application Centric Infrastructure, or ACI, in 2013, and growth has been swift. During the last reported quarter, ACI grew by more than 200% year over year.
The major alternative to Cisco's ACI comes from VMWare (NYSE:VMW), a company best known for virtualization products. VMWare is strictly a software company, so it doesn't compete with Cisco's networking hardware, but it does compete with ACI with its own take on SDN called NSX. NSX is compatible with a variety of networking hardware, including hardware from Cisco. NSX is also growing fast, and during VMWare's latest earnings conference call, the company stated it believed the number of NSX production customers was larger than any of its competitors numbers.
Why NSX is not a near-term threat to Cisco
While the growing presence of NSX would suggest that Cisco's hardware empire is at risk, given that NSX supports Cisco's major competitors, that's actually not the case. According to Dominick Delfino, VP of worldwide systems engineering at VMWare, about 75% of NSX clients run the software on top of Cisco hardware.
This speaks volumes about how entrenched Cisco's hardware truly is; Swapping out Cisco's switches for those of a competitor is not a trivial task. Cisco has faced lower-priced competition for years, and it has remained the dominant market leader despite this competition. The proliferation of NSX doesn't really change the competitive dynamics of the industry, at least not in the short term.
I wouldn't expect Cisco to start losing market share, regardless of how fast NSX is growing. In the long term, Cisco would certainly prefer customers to use both its hardware as well as ACI. This would create an even stronger lock-in effect, as the cost to switch to an alternative would be even greater compared to a customers using only Cisco's hardware.
Whether both NSX and ACI can be successful simultaneously remains to be seen. One may become the overwhelming standard, and Cisco would obviously prefer the winner to be ACI. If NSX comes out on top, the likelihood that networking hardware becomes commoditized certainly increases, but Cisco's competitive advantage doesn't disappear. Price is only one factor, and the underlying hardware still needs to be reliable and perform well, regardless of the software running on top.
A great value
There's clearly some pessimism hanging over Cisco's stock, and this has created an opportunity for those who believe the threat of SDN to Cisco's business is overblown. Backing out the net cash on Cisco's balance sheet, which totals about $6.85 per share, the stock trades at just about 10.5 times the trailing-12-month GAAP earnings.
For a company as dominant as Cisco, this valuation doesn't make much sense. Of course, it's not impossible that Cisco falls from grace; once-dominant companies have certainly been destroyed by unforeseen developments in the past. But at the stock's current valuation, there's a significant margin of safety. Cisco doesn't need to post rapid growth for things to work out well for those who buy at these prices, and while predicting the future is hard, particularly when it comes to technology stocks, the risk-reward equation looks favorable for investors.
Timothy Green owns shares of Cisco Systems. The Motley Fool recommends Cisco Systems and VMware. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.